Should Policy Makers in Emerging Markets be Concerned about “Tapering”?

The US and European economies are showing some signs of recovery from the global financial crisis that began in 2008. As a result, the US Federal Reserve Bank is considering phasing out, or “tapering”, the extraordinary monetary policy measures through which it responded to the crisis. On May 22, Fed Chairman Ben Bernanke testified before Congress that the Fed may begin to reduce the size of its bond buying program. There was an immediate withdrawal by investors from stocks and bonds in emerging markets. The World Bank's East Asia and Pacific regional update estimated that in East Asia alone $24 billion was withdrawn from equities and $35.2 billion from bonds. Share prices fell by 24 percent in Indonesia, 21 percent in Thailand, and 20 percent in the Philippines. Yields on 10 year local currency bonds increased by 273 basis points in Indonesia, 86 basis points in Thailand and 76 basis points in Malaysia. The exchange rate depreciated by 18 percent in Indonesia, and about 5 percent in the Philippines and Thailand. Financial markets largely recovered once the Fed decided to postpone tapering in September, but there is still nervousness. The Indonesian Rupiah and Indian Rupee both fell significantly in November, till Fed Chair nominee Janet Yellen signaled that she saw a continued need for the bond buying program.

At some point the Fed will indeed begin to taper. Investors should clearly be concerned as there is a risk of sudden and dramatic falls in asset prices. Should policy makers be concerned? Will there be an impact on growth, inflation or macroeconomic risk that requires a response from policy makers?

When investors suddenly withdraw from markets, it has led in the past to macroeconomic crisis manifested as government default on debt, a recession, hyperinflation or some combination of these. Examples include the ongoing crisis in Europe, East Asia in 1997 and several Latin American countries before that. However, many of the earlier crises occurred in countries with fixed exchange rates or significant foreign exchange denominated debt. Paul Krugman has written a new paper arguing that in countries with floating exchange rates and low levels of external debt, the risks are low. The key, noted earlier by Paul De Graawe is that countries that borrow in their own currency have a lender of last resort - the central bank can always buy bonds and so the risks of default are lowered. A floating exchange rate provides a mechanism for macroeconomic imbalances to adjust, relieving the pressure on interest rates or wages.

In fact, for some countries, withdrawal by investors from financial markets might actually lead to faster growth if a depreciating exchange rate spurs exports. The key is whether such a withdrawal also leads to rising interest rates that can slow the economy. Withdrawal from bond markets has an immediate impact on bond yields through falling bond prices. But the transmission mechanism to interest rates that will affect growth may not be direct. The Central Bank typically can influence short term rates and might even take measures to directly target long term rates. In some countries, governments are able to rely on social security administrations, state owned banks or pension funds to absorb bonds also affecting long term interest rates. All of these frictions are likely to make the transmission mechanism from rising bond yields to interest rates that matter for growth uncertain.

So should policy makers be concerned about tapering? For countries with floating exchange rates, low inflation and limited foreign currency borrowing, the risks to the real economy (as opposed to financial markets) should be limited. Policy makers should let the exchange rate depreciate rather than raise interest rates. Policy makers in countries where these conditions are not met and have significant foreign investors in debt or equity markets will have to use interest rate adjustments and macro prudential measures to manage capital flight. For all emerging market countries, the larger risk might be if the Fed and ECB unwound their extra-ordinary measures prematurely.

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